On November 2, the Federal Reserve brought an end to several months of speculation in the global investment community as it announced a second round of quantitative easing in the form of $600 billion. Leading up to Tuesday’s announcement there was much uncertainty concerning the size and scope of the Fed’s new package. Since late July, it was quite clear that the Federal Reserve would move forward with another round of quantitative easing in an attempt to stimulate a faltering economic recovery in the United States, but the market was largely unsure how large the package would be. Those lingering doubts have now been put to rest as the Federal Reserve announced it would purchase an additional $600 billion of Treasury securities through the end of the second quarter 2011, which basically amounts to $75 billion per month.
Interest Rate Spreads
The primary driver of currency values around the world tends to be interest rates and monetary policy. As a rule of thumb, capital will tend to move out of currencies that offer low interest rates, and it will flow into currencies that offer high interest rates. The reason is simple. Every investment manager in the world has a primary goal of making money for his clients, and how does an investment manager make money for his clients?
Well, of course he finds investments with strong yield. Therefore, countries that offer very low interest rates are not attractive to most large investors; thus, these investors will take money out of those low-yielding countries and funnel capital into higher-yielding countries. This phenomenon has caused quite a stir in the global economy in recent months.
At the outset of the 2008 Global Credit Crisis, the United States, U.K., EuroZone and other major developed nations around the world slashed short-term interest rates in order to stimulate credit markets and attempt to stave off another Great Depression. The quick, bold move worked, and a complete Financial Armageddon was avoided. However, we are now two years after the initial Crisis, and many developed nations still have extremely loose monetary policy in place. This has caused investors to pull money out of those currencies and place it in higher-yielding currencies such as Brazil, Thailand, India and many other emerging markets.
Emerging markets have not been happy with this capital flow shift because it is threatening to destabilize economic growth in their own countries. Emerging markets such as India need foreign capital flow in heavy amounts coming in to India because these increased capital flows will make credit easier to obtain, which will generally stimulate economic growth, among other effects. However, there is a tipping point at which the increased capital flows actually become counter-productive because they drive up the currency rate so high that exports begin to become unattractive to foreign investors, and most emerging markets, India included, are still heavily dependent on exports because their domestic economies are not fully developed.
Currently, emerging markets are beginning to take measures to fight off further capital flows into their countries. For example, India just raised its interest rate, and in the accompanying statement, Central Bank Governor Duvvuri Subbarao said, “While the ultra-loose monetary policy of advanced economies may benefit the global economy in the medium term, in the short term it will trigger further capital inflows into emerging market economies and put upward pressure on global commodity prices.”
Excess Liquidity
The primary concern for countries such as India regarding the Fed’s QE2 is, where will all that excess liquidity go? Many analysts are concerned that a large percentage of the $600 billion will never get into the U.S. economy. Instead, investors will simply take this increased liquidity and invest it in foreign nations where interest rates are more attractive, such as India. India is already showing possible signs of inflation, which is why it increased interest rates this week, and a marked increase of capital flow into the country will most likely threaten to destabilize India in the near term. Therefore, look for emerging markets to join together and become more unified and vocal in their criticism of the Federal Reserve’s new decision. Forex software can help track these volatile currency movements.
